Strategies For Business Succession Planning: More Art Than Science
Once a business owner dies, becomes disabled or retires, one of three things can happen to the business: It can be sold, continued by a family member, or liquidated.
Unfortunately, liquidation is more often than not the unintended default plan. Recent reports have shown liquidated businesses lose 60% of their fair market value due to the forced sale of inventory and equipment, the difficulty of collecting accounts receivable, and the zero value placed on goodwill and other intangible asset values.
But this situation can be avoided through a properly designed business succession strategy. Some of the questions that need to be addressed are found in Figure 1.
Business owners should also be aware that financing the buyout through a loan might not be the most cost-effective strategy. Many states preclude a corporation from purchasing its own stock except out of surplus funds or from a stated amount of capital. Corporate creditors cannot be placed in jeopardy.
Even though an installment sale may still be an option for a given business owner, deferral of long-term capital gains taxation may be unavailable under applicable tax law. Also, a corporate redemption sinking fund can cause an unintended accumulated or retained earnings excise tax assessed at the highest marginal rate for individuals.
All these factors require that business owners proactively design a plan if they want to successfully meet their business continuation objectives. Nowhere is the adage truer that a failure to plan now is a plan to fail later.
The strategy that business owners select depends upon:
(1) The type of business entity involved.
(2) The number of owners, their age and ownership differences.
(3) Whether or not cost basis adjustments are desired.
(4) What effect the carry-over basis income tax regime imposed by 2001s Economic Growth and Tax Reform and Reconciliation Act for the year 2010 may have.
(5) Whether or not the application of IRC Section 318 family attribution may cause an adverse tax consequence.
Lets review strategies available to target those concerns that have a higher priority for all parties involved:
Stock Redemption or Entity Buyout. This strategy is desirable when one or more of the following issues must be addressed: there are more than two shareowners; the corporation is in a low marginal income tax bracket; cost basis issues are not relevant; significant age and ownership interests among the owners exist; neither corporate creditors or the potential for an alternative minimum tax consequence are a concern; and family attribution is not an obstacle.
Family attribution concerns are only applicable to IRC Section 302 stock redemption plans, which require the corporation to redeem all of the stock actually or constructively owned by the deceased owners estate. IRC Section 303 partial stock redemption plans are not affected by the attribution rules and permit a redemption of a sufficient amount of stock from the estate to pay death taxes, administration, and funeral expenses. Properly structured buyout plans are treated as a capital transaction, a payment in exchange for the stock.
Corporations can deduct the purchase price of their stock when it is either sold to or purchased by an employee stock option trust (ESOT).
S-corporation stock redemption plans present some unique opportunities. Generally, at the death of a shareowner, the surviving owner realizes a pro-rata step-up in cost basis based upon his or her ownership interest. A full step-up in cost basis for the surviving owner may be available if the timing of the close of the taxable year after the death of an owner, the execution of a buyout note, and the receipt of the life insurance death proceeds are in accordance with relative tax law.
Also, the AMT is not an issue for these entities. However, care must be taken when an S-corporation converts from a C-corporation. If corporate assets are sold within 10 years of the conversion a double tax may result. Gain recognized at the corporate level is taxed as well as any gain realized by the shareholder upon the liquidation or distribution of the sale proceeds.
